Market Timing Works; Emotional Investment Doesn't

This article by Richard M. Todd was recently published in the Denver Business Journal, Volume 59, Number 49, May 23, 2008-May 29, 2008, (Denver Business Journal). A reprint of the article may be found at this link (Reprint).

There's no doubt that market timing works. If investors can buy at market bottoms and sell at market tops, they'll add significant value to the bottom line. The converse is also true. Making poor market-timing decisions can have a dire impact on portfolio returns.

The problem with market timing is that the investor (or adviser) must continually link correct decisions in order to add value. There are skillful managers, but we have yet to find one that adds value through market timing.

If professionals can't add value (some claim to, but use faulty statistics to prove it), why do many investors believe that certain experts have this special ability?

Hindsight is always 20/20, and many investors rely on a combination of hindsight and emotional influences. Investment decisions that are based on fear, hope and greed will lead investors to buy when others are buying, and sell when others are selling -- a guaranteed way to generate horrible investment results.

Successful investors do the opposite, and not because they are contrarian or have cast-iron stomachs. Success is a by-product of being process-oriented and having a framework that provides a consistent and methodical basis for making decisions.

During the tech bubble in 1999 and early 2000, investors rationalized new thinking, in which tech companies could sustain incredible growth rates and defy the laws of mathematics. Conversely, in late 2002 and early 2003, investor gloominess was extreme. Many investors had the perception that the investment environment was exceedingly dangerous after the S&P 500 was down nearly 50 percent.

We're reminded of this gloominess today. Many investors prefer investments after periods of strong performance -- typically when valuations are high -- and are afraid of investments after down periods. For instance, why were investors flocking to high yield bonds yielding only 3 percent over Treasurys in fall 2007, and today shun the same bonds yielding 10 percent over Treasurys?

The best way to insulate an investor from the powerful emotions that drive short-term market movements is to have a strict, proven process.

A diversification and asset allocation policy that includes investments with a number of complementary strategies is extremely important. A haphazard approach to diversification can lead to concentrations in areas and lack of exposure to specific opportunities.

A rebalancing strategy is crucial. Rebalancing is the process of reallocating investments back to the original percentage of the portfolio. This approach forces something that most investors lack the discipline to do -- buy low and sell high.

Well-thought-out and reasonable expectations of future investment returns are important as well. Expected rates of returns should be established in advance and risk should be quantified as well. What is the maximum "draw down" or negative return that can be tolerated? This critical question is directly linked to the asset-allocation process and the investor's portfolio design.

A methodical process for monitoring and evaluation is important in the overall process. Patience and a long-term focus must be emphasized. If an investor has a short-term horizon, the likelihood of not meeting goals increases dramatically.

Emotional investing seldom works. Fiduciary law grasps diversification and process -- not market timing. Although the theoretical returns of market timing look compelling, results always have been negative because continually linking successful decisions is impossible.